In our earlier discussion of the uses of aggregate demand and aggregate 
supply analysis in textbooks, the proposal was made that these concepts 
make it easy, or possible, to represent the effects of an aggregate 
demand or aggregate supply shock. The textbook and professional 
terminology nowadays defines shock as a shift of aggregate demand or 
supply that is not caused by government.

I had not kept up with the literature on "shocks." So I made a point to 
pay attention to this in my recent readings. Consider the following four 
examples of shocks that are taken from a Journal of Economic 
Perspectives article by Lars Swensson (The Journal of Economic 
Perspectives, Vol. 17, No. 4. (Autumn, 2003), pp. 145-166.)

1. Bursting an asset bubble: This cannot be an exogenous shock. The 
money that disappears from the asset market and that causes the asset 
price to fall must be put somewhere else. It must cause other asset 
prices to rise. So whence the shift in aggregate supply or aggregate demand?

2. A correction of over optimistic growth and productivity expectations: 
This cannot be an exogenous shock. If entrepreneurs begin to expect 
slower growth and productivity, they will reduce the demands for funds. 
Savers will respond by either increasing or decreasing their saving, 
leading to the opposite effect on consumer spending. Whatever change in 
aggregate investment spending occurs will be offset by a change in 
aggregate consumption spending, as we know from the crowding out effect. 
So whence the shift in aggregate supply or aggregate demand?

3. Increased doubts about future pensions and benefits due to 
demographic developments and/or reckless fiscal policy: If consumers 
begin to be concerned that pension promises will not be kept, they 
presumably would reduce consumption spending and increase saving and 
investment. So whence the shift in aggregate supply or aggregate demand? 
Could it come from increased liquidity or gambling on asset prices? It 
is hard to believe that prudent savers would use their increased savings 
in these ways, at least as a general rule.

4. Increased uncertainty for geopolitical or other reasons. I have no 
idea how to handle this one. Perhaps Professor Svennson means this to 
refer to the common idea of an oil price shock. So let's ask about that 
case.

5. Oil price shock: The oil price shock is one example of a much larger 
class of possible events that, other things equal, would reduce the 
outputs of many goods that could be produced with given amounts of other 
inputs. Both aggregate demand-aggregate supply analysis and the simple 
quantity theory can be used to predict that real output would fall and 
the price level would rise. But what is the advantage of AD-AS analysis? 
I suggest that it has a disadvantage. The whole framework is constructed 
with idea in mind that real output is related to employment of work. Yet 
there is no reason to think that a decrease in the amount of some other 
input besides work would reduce (or increase) the amount of work. In the 
standard textbook model, we might propose for simplicity that, beginning 
with a full employment macro equilibrium, a decrease in aggregate supply 
would raise prices and reduce real output. But we would have to add that 
it would change the full employment level of real output. It would be an 
error to say that the supply shock could cause greater unemployment 
without some further, more complicated analysis. For the same reason it 
would be an error to say that some kind of macro policy might be in 
order to offset the effects.

If you don't buy the reasoning, perhaps you will buy the empirical 
research. It has been argued that international oil price hikes were 
responsible for stagflation. Indeed, AD-AS analysis has been defended on 
this list as a means of explaining stagflation. But research on this 
issue suggest that this is a misuse of the analysis. (Not to mention, of 
course, the absence of stagflation at the present moment in history, 
following a recent hike in international oil prices.)

Systematic Monetary Policy and the Effects of Oil Price Shocks
Ben S. Bernanke; Mark Gertler; Mark Watson; Christopher A. Sims; 
Benjamin M. Friedman
Brookings Papers on Economic Activity, Vol. 1997, No. 1. (1997), pp. 91-157.

Barsky, Robert, and Lutz Killian. 2001. "Do We Really Know That Oil 
Caused the Great Stagflation?" NBER Working Paper 8389.


Pat Gunning